Advices for preparing the budget

Money does not buy you happiness, but lack of money certainly buys your misery.
Daniel Kahneman

On this occasion, at Steering Bird, online advisers in business direction and management, we will refer to budgets and some common mistakes that we have observed in our experience, giving you some advices for considering in budgeting process.

What is a budget?

Budget: a way of going broke methodically.
Groucho Marx

A budget is an estimate of income and expenses for a specific future period of time. Is an essential part of the planning process and can be made for any financial and economic unit, be it a person, a team, a company, a project, a government or any other entity that generates costs and income.

The objective of the budget is to prepare in the best way for the following periods. The budget must be compared with the actual data. Although it seems absurd, sometimes this comparison is not made. Depending on this comparison, at the final result level, we can have:

  • Budget with surplus: higher than the real one (higher profits than expected)
  • Balanced budget: relatively the same as the real one
  • Budget with deficit: less than the real one (greater losses than expected)

There is a step prior to the preparation of any budget and it consists in making estimates, both of income and expenses. Once these estimates are gathered, we can just prepare the budget.

In simple terms, budgets can be classified into fixed and flexible.

  • Fixed budget: It does not change during the term of the budgeting period. Even when there are changes during the budget period, both the accounts and the original values ​​are preserved.
  • Flexible budget: A budget is made based on a referential value and variables. The budget figures change depending on the level of sale, the level of production, etc.

Incremental Budget vs. Zero Base Budget

Watch the costs and the profits will take care of themselves.
Andrew Carnegie

From the point of view of their preparation, the budgets could be classified in Incremental Budget and Zero Base Budget (ZBB).

Incremental budget, also called traditional, is the most common of all and is made with increments on the previous data. It focuses on the new expenses, assuming they will be higher or lower than the previous one. Thus, when your estimation for sales expenses increases by 5%, or decreases by 2%, you are making a traditional budget, based on the previous data.

On the other hand, zero-based budget, as its name implies, starts from a “zero base”, analyzing all the expenses for the new period, without considering the previous base. Thus, budgets are made based on needs, on what will be required for the next period, even when it is higher or lower than the previous or actual spending. The goal is to analyze each unit or function in detail and if any budget account is no longer needed, it is simply eliminated. This would allow optimizing the allocation of resources.

A zero-based budget requires enormous effort to perform detailed analysis of each item. For this reason, the simplest thing would be to apply it partially, only on some accounts, units or functional areas.

Mistakes in preparing the budget

Too many people spend money they haven’t earned, to buy things they don’t want, to impress people that they don’t like.
Will Rogers

To prepare Budget is not an easy task, and for some people it is somewhat tedious. A complaint we have often heard is to consider it a task outside the activities of the position, even when it is part of the responsibility.

Here are some common mistakes in budgeting, both personal and your company:

  • Unrealistic budget: This is the most common mistake. For example, your sales budget is too optimistic, thinking that you will sell much more than you could sell, or your cost budget is too small. The result is a total disaster, where the real data will tell you that you no longer have resources or your unit is not profitable.
  • Keep the same previous budget: This happens when you do not prepare a new exercise and simply repeat the previous one, without changes. However, the conditions of a period are never the same as the previous period. Without going any further, the conditions of 2020, with the coronavirus crises, are very different from those of 2019. Maintaining the previous budget is useless. Just think that only the effect of inflation will make it insufficient.
  • Not considering each account line: Another recurring mistake is to focus only on some budget lines, forgetting other items. There are people who, by focusing on the larger numbers, neglect the small ones. Some expenses or income of a non-recurring nature are particularly left out of budgets.
  • Take little time to do it: Most people don’t take enough time to budget. Then when they face the deadline, they send anything, which is usually the same old budget plus some global increase factor.
  • Do not consider contingencies for expenses: Have you ever had an unforeseen expense? We refer to that extra expense that you did not consider and that makes you lose everything. Well, for this you should consider a contingency line in your budget. It is not another expense, it is a fund that you will use in case of something unforeseen. It is an important item and you should take the time to make an estimate and incorporate it into your budget. The lack of contingencies is something that we have observed a lot in projects.
  • Psychological anchors: In previous articles, we talked about psychological anchors and how they affect our decisions, even when we are not fully aware of them. Many times, when you have to estimate a number to make your budget, you go to a random estimate, or you repeat a previous one, or the increments you use tend to be the same number with a slight adjustment. Here we want leads you to think about the budget exercise you are doing. Are you really generating a good estimate or are you working on anchors?

The Planning Fallacy

The confidence people have in their beliefs is not a measure of the quality of evidence but of the coherence of the story the mind has managed to construct.
Daniel Kahneman

We have already indicated that budgets are sometimes too optimistic. It is not just our perception. From Tu Mejor Tú they point out that Daniel Kahneman, in his book “Thinking, Fast and Slow” (2011) introduces a term created in conjunction with Amos Tversky. It is the planning fallacy, a phenomenon that appears when plans:

  • Unrealistically, they tend to be in the best possible scenario.
  • They are susceptible to improvement when compared with statistics of similar cases.

As can be seen, these are excessively optimistic plans, which can be improved. Below, we reproduce two of the examples cited by Kahneman (2011):

  • In July 1997, the proposed new Scottish Parliament building in Edinburgh was estimated to cost up to £40 million. By June 1999 […] was £109 million. In April 2000, legislators imposed a £195 million “cap on costs.” […] That estimated final cost rose twice in 2002, ending the year at £294.6 million […] The building was finally comanspleted in 2004 at an ultimate cost of roughly £431 million.
  • In 2002, a survey of American homeowners who had remodeled their kitchens found that, on average, they had expected the job to cost $18,658; in fact, they ended up paying an average of $38,769.

However, the excessive optimism of planning and budgeting, on the part of those who make them and those who make the decisions, is not the only cause of these increases. Construction companies generally make a large part of their profits due to additional works to the original plan. In this case, the client’s responsibility is the review and control of the budgets and their actual values.

And you, have you ever made or controlled a budget with errors? We call on you to dedicate time to this administrative process, or to review in detail the budgets you receive.

We are Steering Bird, online advisers in direction, management and finance. We specialize in business analysis, control and analysis of investment projects, results analysis, processes of budget and forecast, etc.

Contact us if you need help. We invite you to learn about our services and read our articles.

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